The derivative market growth is spectacular. In order to understand modern day finance you must at least have an idea about what derivatives are and how they function. Monitoring certain derivatives markets can be crucial in understanding market risk which has a direct effect on equities as equities are usually the last to respond to market developments in terms of other securities. For investors who do not have a large capital base or tons of money to invest with, understanding current market risk is vital. We may not have the cash/liquidity to ride out spouts of deflationary markets. Seeing your stock position down over 50% can be disheartening. Above is a chart of the growth in the derivatives market. Whats interesting is the spectacular growth in the interest derivatives market. What is a derivative? Investopedia explains below:
Definition of ‘Derivative’
A security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage.
Investopedia explains ‘Derivative’
Futures contracts, forward contracts, options and swaps are the most common types of derivatives. Derivatives are contracts and can be used as an underlying asset. There are even derivatives based on weather data, such as the amount of rain or the number of sunny days in a particular region.
Derivatives are generally used as an instrument to hedge risk, but can also be used for speculative purposes. For example, a European investor purchasing shares of an American company off of an American exchange (using U.S. dollars to do so) would be exposed to exchange-rate risk while holding that stock. To hedge this risk, the investor could purchase currency futures to lock in a specified exchange rate for the future stock sale and currency conversion back into Euros.